Is the Conventional Strategy for Retirement Planning Wrong?

Retirement Planning

Just about everyone believes that as we get nearer to retirement, and especially after retirement, we should be more conservative with our investing. Is this the right approach?

There are good reasons behind our recommending that people be more aggressive with their investments early in life and more conservative as time goes on, and this remains a fundamental principle of investment.

The idea behind this is that as you get closer and closer to the time where you expect to spend your retirement savings, your investment window gets shorter and shorter, and it therefore makes sense to take this into account.

For example, someone who is 35 would typically have 30 years or more left before they retire, and even longer when we figure in the period between when they start cashing in on this money and when they have cashed in a substantial amount of it. If we only have a little saved up, it may not take us very long at all to spend it, but hopefully this isn’t the case and our money will last us through our final years.

The only reason why this time horizon matters is because if we use completely passive investment strategies, as most people do, we need to make sure that we have enough time for this strategy to be able to play out in order to manage risk properly. All of this discussion is about managing risk, and if we are handing everything over to time to manage it, we need enough time for it to do its work.

Given that neither our entries or exits are timed, as we invest when we can, throughout our working years, and when we cash out with this strategy, it is because we need it, not because it’s a good time to get out, we will need something to manage the risks of our investment plan, and what we’re relying on is the ups and downs of the market evening out and holding long enough to allow this all to happen.

As a general rule, we can take any point in time and move ahead 30 years or so and see a positive return. There will be some waxing and waning in between, both with bull and bear markets of various lengths, and since we’re not timing anything, we want to be confident enough that we won’t be riding the bear down to the point where we end up cashing out at an opportune time.

We can’t really do this comfortably or even sensibly with periods not long enough, and this can make things like a crapshoot where we are rolling the dice to be OK in retirement

When markets are beat down, this buy and hold strategy tells you to hang on and wait for it to come back, and the bear market of November 2007-March 2009 can serve as a good example of this. People who were cashing out because they needed to sell some stock positions to live on had no choice, and this need conflicts with the overall strategy and can involve us selling at the exact wrong time with losses that we should not be suffering.

This is All About Not Exposing Ourselves to Unacceptable Losses

At other times, we might retire and then see the market decline through most or all of our retirement, resulting in our having a considerably smaller nest egg than if we even had put the money under our mattress.

During bear markets, the mattress approach can be far superior actually, as can putting money in a savings account, investing in certificates of deposit, or in treasuries or other debt instruments. During bull markets, nothing beats stocks as far as investing is concerned, so it all depends on what environment we’re in.

The buy-and-hold approach absolutely requires enough of a time frame to reasonably assure us that we will be all right in most cases, providing the likelihood of both a reasonable return and reasonably contained risk. We could instead just get out when the bears take over the den, but if we do not, we still need to be responsible with this.

This will require our backing away from stocks as we get closer to retirement and perhaps be out of them completely at some point, where it no longer makes sense for us to have even a portion of our portfolio in them due to not enough time left on the clock. Financial advisors tend to be way more aggressive in their recommendations here if anything, as many may just have a passing understanding of the dynamics involved.

Financial planner Michael Kitces takes this a step further though and believes it is not only wrong to become more conservative over time, he actually believes we should be more conservative leading up to retirement and much more aggressive once we get there, which he shared at an investment conference last week. This may be very counterintuitive, but it at least bears examining to see if there actually is any merit in this idea.

Stocks Do Provide Higher Returns, if Used Carefully

He starts the discussion by pointing out that the studies show that moving more of our money out of stocks and into other less volatile assets has a negative impact on our retirement income. The goal here is actually to do just that in favor of not subjecting our money to too much risk. We well know that stocks provide more income on average than bonds do, so this should not surprise us.

This is why people diversify with bonds in the first place, well knowing that their returns will suffer but this will at least make it more likely that if things turn sour, they won’t be hurt as much as if they did not hedge this way.

The key thing to realize here is that unless we are studying periods where we’ve had a serious bear market, and we’re just looking at periods of time where the going has been good, this is going to skew the results.

It’s not on balance that we’re trying to address here, and yes, on balance stocks will win out, what we are seeking instead is to limit the drawdowns. If we have half a million dollars, and on average, we will grow it to $600,000 with stocks and $550,000, if we’re down to $300,000 in some of these cases, that may not be acceptable at all.

We’ve been in a bull market for a while and sometimes people forget that we can go a long time where things just keep going down as well. If we end up losing a quarter or more of our hard-earned savings because the stock market is on vacation for a while, we can easily dash our retirement dreams and be left struggling far more than we had planned.

Kitces wants us to only have 30% exposure to stocks leading up to retirement and then ramp this up to 70% once we retire. The 30% might seem low but that may actually be too aggressive at retirement at least if you are just going to hold these stocks, and going to 70% in retirement would seem to be all the more so.

He tells us that by moving from this 30% to 70%, this will allow us to buy stocks more cheaply. This will of course depend on the state of the market, but generally speaking, stocks are more expensive to buy over time, and we certainly can’t count on their prices dropping just because we’ve now retired.

Once we’ve made the move, we aren’t told what we are supposed to do if the market takes a big hit, which is the real concern with buying and holding in retirement, aside from foregoing the potential better returns that stocks provide while we’re waiting for this transition to happen. There is no exit plan provided here and presumably we’re supposed to just grin and bear it and perhaps do some praying.

There is too much at stake to allow our nest eggs to be exposed to the normal risks of holding a lot of stock in retirement given we have no good plan to deal with the problems that may occur, and it’s way too risky to add to this problem considerably.

Kitces is right though about the conventional approach being far from ideal, although his idea ends up taking us even further away from it. If we are really looking to optimize our retirement income, we should be sticking with stocks all the way, when it makes sense to, and avoiding them when it does not make sense to, where at these points in time we would have our money elsewhere, where we may expect a positive return instead of the negative expectation that bear markets offer us.

Investing really is all about managing expectations, and a positive expectation is required not just when we buy stocks, but every step along the way. If people don’t want to do anything to manage this, then there’s not much else left but to use the buy and hold approach, although by the time they get to retirement and even before this point, this strategy isn’t a good one because we can no longer afford to ride out the long periods of negative expectations.

We could put all of our money into stocks at retirement, not just 70%, and manage the risk involved another way, by simply asking ourselves if it is a good time to be invested in stocks right now. If the answer is a clear no, we should know what to do, and that alone can provide us far better risk management than any strategy whose only plan is to alter the percentages of our asset allocation with no regard to conditions or expectations.

Ken Stephens

Chief Editor, MarketReview.com